Sunday, February 17, 2013

Risk and subsidies

This post is in response to a comment on the previous post Oh, the mess we’re in!. Blogger is unable to allow long comments so I've made a new post for the response.

Here's the comment:

" Mark said...

Thanks for replying to my comment. You're saying that the risk used to be that the studios would be held to ransom in some way, but now that's changed -- to a risk that the studio will find itself in financial difficulties.

I think it's unlikely that's a new consideration. The risk that the VFX house will be unable to complete the contract for some reason will already feature. Work gets pulled from even high-profile VFX houses which I see as the studio managing this risk in a hands-on way, and I expect they will continue to do so.

I think the reason I'm commenting on your blog is that it (and many others) are reducing the discussion to a simple one of "subsidies have introduced risk to the VFX business." Not acknowledging any existing risk is (to me) an indication that risk management is not high enough on the agenda within a sizable part of the VFX industry."

'I think it's unlikely that's a new consideration.'

Actually it is. Obviously studios wouldn't award projects in the past to companies that were just starting up or which there were indications they would fail from the get go.

Now there may have been a company or two that closed during a production in the pre-digital days but I can't think of any. But as you can see with R&H, DD, Meteor Studios, etc. that's a real risk now where it wasn't before. And this is as risky of the big companies as the small companies. The risk that a company may not be able to handle shots as desired or they may not be able to handle hundreds of new shots was always there but a company going out of business while working on a project? - That's a new one. Do the studios going to Weta or ILM think that tomorrow they may get a call saying they closed their doors while working on a project? No. And that was the case with almost all vfx companies pre-digital as well. Yet many projects are not done 100% at Weta or ILM. The work is split up among a few companies, not to reduce their risk of going out of business but in an attempt not to have all of their eggs in one basket. And by that I mean the studios don't want to hear about delays or problems or change orders. And they think it's cheaper.

A studio can check the quality of the work the company has done for other films, they can check their budgets, meet with the crew, they can talk to other studios, producers and directors - all of this to assess the risk and quality factor before they sign a contract. But the thing they can't do is check the books of the company and do a true assessment of their financial stability. In the past, they never had to.

Now a studio may pull work from a company and that's aways happened if the company wasn't delivering what was requested in the required time. There have been certainly 911 calls (emergency) when work needed to be shifted or shots were added. But that's a risk that is evaluated before the contract is signed and is monitored by the studio. This is not something they're blindsided with. A company calling them up and saying we're filing for bankruptcy tomorrow (or next week) is a much different thing and a much higher level of risk.

The studios have many risks when they make a film. They take on that risk with their crews and locations. But vfx is a 3rd party since the studios don't want to take on running their own vfx company (too risky). The real risk is laid at the doorstep of the vfx company. But the risk for the company is constantly changing by external forces which they have no control over. And in many cases their clients are the ones putting the companies at more risk either directly or indirectly.

'I think the reason I'm commenting on your blog is that it (and many others) are reducing the discussion to a simple one of "subsidies have introduced risk to the VFX business." Not acknowledging any existing risk is (to me) an indication that risk management is not high enough on the agenda within a sizable part of the VFX industry.'

No offense but this sounds like a certain management software company or a studio talking and not someone working in visual effects or visual effects management. Would there be some risk without subsidies? Yes but they'd likely to be much less.

As pointed out the studios and regions (countries, states) have created a situation where quality and efficiency are lower priority. If it were a true free market then those companies who were doing good work efficiently would be rewarded by more work. They'd be able to make a profit and be on much firmer ground financially. The companies that did poor work or that were inefficient would see their profits go down and possibly have to close. Studios would be clearly able to see the different levels and know ahead of time what their general risks were. This is natural evolution. Just like in nature the weak ones would be dying off and the strong would survive.

But now you've added in subsidies into the mix. It's no longer evolution based on quality and efficiency. It's evolution based in large part on politics. And those politics change frequently. Companies that would be strong and survive in a free trade market now find that there is no way they can cut costs 50% or more. They find they have to invest $1 million dollar into a satellite branch they don't want and didn't plan for. And companies that wouldn't even exist without subsidies now exist only due to the subsidies. Companies that were small found themselves very big in a short time not because the companies were the best at what they did but because of subsidies.

Imagine you've got 5 runners in the Olympics and you give some of them motorcycles. Is that fair? Is that a way to truly assess which runner is the best? Are people surprised when the actual runners don't win? Which one would you bet on?

Imagine a restaurant in a town and it's doing well. In fact it's very good and people are coming from other towns. And in another town right next to the first town the city government decides to pay for 50% of all orders at a similar restaurant. Don't you think that would have an impact on the first restaurant? Almost all of the people from both towns would flock to the one that they could get food for 1/2 price.

Is there a way for the first restaurant to compete with that? No. There are certain food, labor and building costs that they can't trim. They're not making over 100% markup so it's impossible to cut their prices 50% and still make any money. What are their choices?
1. Close their doors
2. Try to offer food at the same price. And this will bring back some of the customers but since they're now losing money every month it's simply a matter of when they will close their doors.
3. They can open another restaurant in the town with the discounts. Now they have the extra burden of a duplicate restaurant. They have doubled their building and overhead costs. They've had to hire a manger, hostess and the entire group of chefs and wait staff just for this new place. Do they have enough money to do that? Will that added unexpected cost now make them more at risk of going out of business? Yes is the answer.

Now imagine that another town right next to these two starts offering a 70% discount. Now where does that put the owners of the restaurant? Do they now build a 3rd restaurant in this new town? Do they try to lower their price to match? And with the more lucrative restaurant business in this new town, there will be more restaurants built by those who haven't done this before. The townspeople have paid their taxes and the town council has decided that offering food coupons is much more important than putting the money into their schools or their decaying bridges. There's no winners here except for the customer.

Are subsidies the only reason for troubles of the visual effects industry? No but it is a major reason. Natural evolution would tend to solve problems of poor management and other flaws by having them go out of business. Is there a risk? As in all of filmmaking, yes. Is the risk of a company running out of money on a project much greater now? Yes. See the restaurant example of options for a company. None are good. And it's not a question on how good management is at that point, you can't do the work for 1/2 price. And that's whats created the largest risk - closing doors even while working on projects.

And lets not forget when studios do stop or pull projects that creates a huge loss for the companies that was unexpected. As I say, the companies take on a fair bit of risk outside their control. Now they're on even shakier ground. The studio that pulls 1/2 their work can't plead ignorance that they increased the financial burden of the company and increased the risk the company could go out of business. Between these types of actions and the subsidies it's no wonder some companies go out of business.

9 comments:

I wonder about the VFX houses getting stuck with the bill if a studio decides at the last minute to pull work away from the VFX house after they've already done a fair amount of work on the project. Case in point, R&H was well into lookdev on some of the projects that were pulled.

If you were to hire a lawyer to handle a case for you and somewhere along the line, you decided that either you no longer wanted to pursue the case or you decided you wanted a different lawyer to handle it, you'd still be stuck with the bill from the lawyer for the work done up til that point wouldn't you?

How is it that the studios can have a VFX house put countless hours into R&D, design, lookdev, etc., but not have to pay a single red cent if they change their minds? Why does the VFX house get stuck footing the bill?

This has a lot to do with the contract the visual effects company and the studio have in place. A contract is a negotiation so it's a balancing act between being too much for one or the other. Since visual effects companies don't have much leverage and there are a limited number of studios, this is where the company tends to not want to rock the boat. Maybe they asked for it but the studio simply says no or we'll take this elsewhere. And if it's not in the contract then you won't be paid.

Compare that to most contractors and other services. Even if you cancel the work you have to cover all expenses up to that point and in many cases there's a non-refundable deposit or some type of fine or fee for canceling.

Visual effects companies bid for free and it's not unusual for them to do concept art or initial tests for free. It comes down to how much free work to do and do they have something in writing to prevent them from losing too much money.

At Dream Quest if a client wanted to rent a motion control stage months from now they were required to put down a non-refundable deposit. This didn't cover the entire time but it was sufficient to make the client consider it seriously and should they cancel it would at least offset some of the loss of previously turning down work.

I would think that contracts with 100% payable at final are very rare, especially for larger projects. Usually there is a payment schedule based on delivery milestones, 25/25/50 or similar. Depending on how you negotiate your contract, if work is pulled mid milestone, you might be required to return the "unused" portion of a milestone payment, but early R+D and asset builds consume a lot of the initial money anyway. Now that doesnt mean that the early milestone payments actually cover the real work required by the project, so you can get hung out to dry there if you are not careful.

No, no vfx company works for 100% payment on completion just as no construction or other service does. Even for small projects you'd want 1/3 up front, 1/3 part way through and 1/3 at end. But given the amount of money most vfx projects are done with a continuous payment schedule (ie. time) It can be by milestones but that makes the vfx company reliant on the studio to provide material and make decisions at specific times. Rarely happens as planned.

As covered in my <a href="http://effectscorner.blogspot.com/2013/02/bad-visual-effects-business-practices.html>Bad Visual Effects Business practices </a> companies have to figure out a payment schedule that makes sense for the project and that doesn't create exposure for losses. If you need a lot of money up front for models and R&D then that should be part of your contract.

Great Post as always, Scott. I think you might also want to mention that while the subsidies are made to the VFX houses, they are somehow not the actual beneficiaries. VFX shops in subsidized markets don't get rich -- they just get by. It's the film studios who actually benefit from the subsidies made to post/VFX houses. They also benefit directly from their own subsidies, yet don't seem to pass on their benefit to their customers, the audience. I suspect that this part of the equation is actually a central part of the problem. Subsidies benefit large companies that sell things in very large quantity. Subsidies hurt companies that sell few things to fewer customers. John Textor either failed to recognize this or thought he could make DD big enough and expand its market enough (to students I guess?) to profit from subsidies. Or perhaps he just wanted to make sure he got paid and the heck with the business...

What I think is important about this is that the imbalance between the studios and VFX shops is being magnified by the subsidies. It's perhaps also a factor in the politics. Many people have wondered why California and the US don't retaliate in kind, by heavily subsidizing VFX shops. Could it be as simple as the fact that California and the US have a much greater interest in securing the wealth of the major studios, which are already based there? If I were a studio lobbyist, I'd want my client to continue to benefit from foreign subsidies via VFX houses in subsidized economies. I wouldn't want to throw all that benefit away in order to let a bunch of local VFX suppliers survive or compete better. If you look at the balance sheet of the studios, it sure looks like they are essentially pulling free money into the US economy by taking their VFX work to heavily subsidized vendors.

Forgive me if this is a repost. I think my comment just got eaten but I'm not sure!

Great post as always, Scott.

Have you considered that the subsidies essentially amplify the imbalance between the studios and the VFX vendors? Because the studios sell things in immense volume to a large and eager market, they actually can benefit directly from market and tax subsidies (which they too receive -- look at the New Zealand deal that's coming to light). VFX houses sell a very small number of things to a tiny, reluctant market. So subsidies directed toward the VFX houses don't make them rich, or even particularly profitable -- they just stay barely afloat, and pass virtually all of the subsidies' benefit on to their customers -- the studios.

This is something that John Textor either neglected or thought he could grow DD into taking advantage of, perhaps by broadening its market to include credulous students. Even though DD was the recipient of the subsidies, the only people who benefited were DD's clients, and perhaps Textor himself.

The imbalance between the studios and the VFX vendors, and the impact that subsidies have on both of them may also be influenced by politics. Many people have wondered why California and the US have been so reluctant to fight fire with fire, and subsidize the VFX and post industry as heavily as other localities. I suggest that it may in part be because California and the US are already the home of the primary beneficiaries to the status quo -- the major film studios. The studios are essentially pulling out-of-state and foreign tax dollars into the California and US economies, via the subsidies being paid to VFX vendors outside of California and the US.

In this reading, it would not be in the interests of the studios, their "industry" lobbyists, nor the governments of California or the US to rock the boat. Creating a trade conflict over foreign subsidies would potentially reduce or even reverse that flow of money. I'm sure that the governments of California and the US, like the government of New Zealand, is much more concerned about keeping the larger film industry prosperous and happy. So much the better if doing that means outside tax dollars continue to flow into their economies via the existing subsidies.

So there are some powerful incentives for some people to keep things exactly as they are. I think it will be very hard to change the situation that the VFX industry faces unless those incentives can be reduced, or opposing, greater ones take their place. So we probably need to look for new sources of leverage, if we are serious about keeping this business running.

You're correct. Subsidies don't actually go directly to the visual effects companies. I covered part of that in the Visual Effects Incentives post.

However the companies operating in areas where there are subsidies do benefit from getting work. That's why R&H and every vfx company in the US has satellite branches in areas with subsidies. They don't get the money from the subsidy but without the subsidy they're not even in the game.

Textor knew there was not money to be made in vfx. That's why he targeted creating an animated film and investing in some film projects (gaining IP or at least a slice of potential profits) (R&H tried to get a slice of a few projects as well but in the end it didn't save them.)

Textor was also hoping to do vfx for military and medical companies. (New territories) And he got Florida to spend the money for a school to teach and use the students as cheap labor. He was trying to harness a number of different areas and not putting to much in the classic vfx model.

The subsides mean that no company is safe and that the work will shift with the winds of politics. And that shifts workers around the world chasing the shops since the shops are chasing the jobs. If there were no subsidies then each company would put it's best foot forward to doing best work most efficiently to stay in business.

I'm not aware of any massive US film incentives at the Federal level. That leaves all the states fighting for a small piece by paying more to the studios. California has a small incentive program but the fact is all of these film subsidies are a losing proposition. Some politicians are smart enough to see that, especially when a state is in bad straits. Look at BC. They have to cut education and increase taxes simply to try to give more money to the studios. Even if California wanted to compete they'd have to offer 40-50% to prevent work from going to Canada. And in turn Canada would bump their subsidies.

In the end subsidies only benefit the very few, who don't need the money and they suck money from necessary government projects. Do away with all of these types of subsidies and you have a chance for things to balance out.

Yes, AFAIK, there are no large specifically-film-related direct subsidies or tax rebates from the Federal government. However, I think it's fair to say that the studios and the media conglomerates that own them are very much the beneficiaries of many obscure parts of the byzantine tax code, as well as the occasional earmark (like, say, fixing up the road that just happens to lead by your about-to-be-built corporate campus).

My point isn't that there's some kind of conspiracy or even particular corruption; it's simply that companies that big and that "important" to the economy are in a position to aggressively lobby for, and sometimes receive, that sort of very tangible benefit. I don't think the VFX industry has anything like that kind of reach or access.

I guess my main point is just that while I agree that everybody (really, just about everybody) would be better off in a world without these subsidies, there are probably some powerful interests that don't feel that way.

And when opposing that much power, we have to come up with even more than sensible, ethical, moral, and economic arguments. We have to recognize the strength of the opposition to the changes we'd like to make and build a strategy that stands a chance of standing up to that opposition. And that's where I'm stymied. Totally out of ideas.

It's easy to say, "let's get rid of the subsidies and have a level playing field." It's really hard to get there from here. I'm not being defeatist -- I really just want to know what we can do that we haven't already done.

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Current state of VFX life

To get up to speed on what's happening to visual effects artists and workers around the world and their troubles:
Life After PI documents one of the many closing of a visual effects company.
This is on Rhythm and Hues which worked on Life of Pi and went bankrupt a few weeks before receiving an Academy award. Life After Pi